10	Information Policy

Your leading rival sues you for infringing several key patents. Do you countersue, using your own patent portfolio as a weapon, negotiate a cross-license, or straight-out acquire the rival? You are facing low-priced competition from gray-market imports of your own discounted products intended for markets in Asia. Can you block these imports to support higher prices in the United States? Seeing consolidation coming, and hoping to support a larger R&D program, you seek to acquire one of your direct competitors. Will the antitrust authorities block your deal? You introduce a new version of your product, and rivals threaten to sue you under the antitrust laws because you have altered the interface they rely on for their products to work with yours. Are you at risk of a large, treble-damage award?

Sooner or later, probably sooner, you will face issues like these, where strategic choices are driven by the rules of engagement in the information economy: just what do government antitrust and regulatory rules permit, and what do they prohibit? In this chapter, we describe the government’s information policy as it relates to the strategies we have discussed so far. By and large, the information sector continues to operate under long-standing rules of engagement designed for the entire economy. We explain these rules, emphasizing the key dimensions for most readers of this book: antitrust and government regulation. We show how these rules operate in practice and identify areas where the old rules are proving inadequate. Finally, we will suggest changes that could be made so that the government supports, rather than impedes, the growth of the information economy.

Our analysis here is a departure from previous chapters, where we have been primarily concerned with information strategy in private, for-profit companies. However, the same economic analysis we have used to examine strategic choices in the private sector can be used to analyze public policy choices. The focus, of course, is a bit different. Instead of looking at strategies to increase profitability, we look at strategies to increase the net social benefits. Luckily, as Adam Smith taught us long ago, competitive pressures between producers will often induce them to make choices that maximize the general welfare. This is as true for Smith’s butchers and bakers as for today’s programmers and chip fabricators: the “corporate centric” view and the “policy centric” view are often not as far apart as one might think.

Since the government’s rules inevitably affect industry participants, no executive in the network economy can afford to be ignorant of government information policy. As Jim Barksdale, CEO of Netscape, puts it: “Netscape joined the Technology Network because as an Internet company, we’ve observed first hand how government can help or hinder the technology industry. We’ve learned that working with the government is far more productive than trying to ignore it.”¹

POLICY OVERVIEW

We have developed three major themes in this book, each of which raises questions for government policy:

• Differentiation of products and prices. The high first-copy costs of information and information technology inevitably lead to price and product differentiation. Strategies involving mass customization, differential pricing, personalized content, and versioning are natural outcomes in such industries. However, these strategies raise antitrust issues about fair competition. Is it discriminatory to charge different users different prices for essentially the same product?
• Lock-in. Since information products work together in systems, switching any single product can be very costly to users. The lock-in that results from such switching costs confers a huge competitive advantage on firms that know how to take advantage of it. This leads to concerns about the nature of competition. What tactics are counted as “fair” and “unfair” competition with lock-in? Will you be branded an aftermarket monopolist under antitrust law if you are the sole supplier to some locked-in customers? If you are such a “monopolist,” how will your strategic choices be limited?
• Positive feedback. Positive feedback based on network externalities is ubiquitous in the information economy. Winner-take-all competition and standards battles are common as rivals vie for temporary market control. If you agree to cooperate with your rivals to establish standards, you run the risk of violating laws against cartels and of collusion. Alternatively, if you compete and win, you may be guilty of monopolization, depending on the tactics you employed to gain or keep control over the market. Even if you avoid antitrust entanglements, you may have to deal with regulatory agencies such as the FCC. The FCC has a long and extensive history of regulating the telephone industry to promote universal service, to impose various cross-subsidies, and to limit monopoly power. Will regulation of these types encroach on the Internet and beyond into networking, or even computer hardware and software more generally?

Your ability to fashion a strategy in each of these areas is directly affected by government rules.

PRICE DIFFERENTIATION

In Chapter 2 we argued that differential pricing was a natural way to recover the high fixed costs of information and information technology. However, the Robinson-Patman Act of 1936 says that such price discrimination is illegal if it “effectively lessens competition,” and many antitrust cases have been brought on these grounds. For example, a group of pharmaceutical drug manufacturers has been facing a massive antitrust action the past several years in part because they each set drug prices lower for hospitals and HMOs than for retail drug stores. The Robinson-Patman Act has been widely criticized on both legal and economic grounds, but it’s the law.

Don’t panic. Clearly, differential pricing is standard operating practice for information products. There are three primary legal arguments that render the vast majority of price differentiation immune from successful legal challenge:

• You are allowed to set lower prices that result from lower costs.
• You are allowed to set differential prices to meet the competition.
• Differential pricing is only questionable if it “lessens competition.”

How can you, or the courts, tell if your pricing will lessen competition? Certainly, differential pricing itself should not be taken as prima facie evidence of anticompetitive behavior. It is true that in some cases differential pricing can serve as an anticompetitive strategy, but price discrimination for information goods is often positively beneficial to groups receiving discounts. Furthermore, as we saw earlier in the book, price discrimination may be a necessary strategy to recover costs and thus to support the creation of content in the first place.

From the economic point of view, the critical question to ask is whether differential pricing allows the producer to sell to markets that otherwise would not be served. In many of the cases we examined in Chapter 3, the answer is clearly yes. If film producers had to set one price for first-run movies in all countries, only the high-income countries could afford to go to the movies. When they can set high prices for high-income countries and low prices for low-income countries, they are able to serve groups of consumers who would otherwise not be able to purchase the product.

COMPETITION POLICY

Most competition laws are pretty vague. The Sherman Act (1890) makes it illegal to “monopolize” a market. The Clayton Act (1914) prevents mergers likely to “substantially lessen competition.” FCC regulations refer to the “public interest.” To make sense of these laws, and the ways they are enforced, we need to consider the philosophy behind them.

Principles of Competition Policy

The underlying principle guiding antitrust law is the protection of competition as a process. If a single firm is victorious and gains a monopoly position based on offering low prices and superior product quality, the competitive process has worked just fine. Congress’s judgment in passing the Sherman Act in 1890 was that this competitive process would ultimately be best to spur economic growth and protect consumers’ interests. The famous antitrust enforcer Thurmond Arnold likened the role of the Justice Department’s Antitrust Division to that of a referee in a boxing match, whose job it is to make sure the fight is fair.

The competitive process can easily lead to a concentrated industry structure, with one or a few firms dominating the market, at least for a time, until they, too, are toppled. This is especially common in information industries, because of the economies of scale involved in creating information and because of the positive feedback and network externalities we explored earlier. The fact is, it can be highly efficient for one or a few companies to supply the entire market. For example, if the minimum efficient scale of operation is large relative to the overall size of the market, a single large firm may be more cost-effective than several small ones. Under these conditions, supporting several firms is very costly, perhaps more costly than working with a sole supplier. The Defense Department has certainly learned this lesson during the past several years as it has tolerated, and at times encouraged, consolidation of its supplier base.

Fair enough. But how does the government and legal system respond when our cherished free market economy spawns a powerful monopolist? Broadly speaking, there are three answers.

First, the government can sit back and do nothing, recognizing that there are economies of scale on the supply and demand sides of the market and hoping that market forces will in time erode the monopoly power. Remember, it is not illegal to have a monopoly, only to “monopolize.” If you obtain a monopoly position fair and square, you are free to reap the benefits that come with market dominance. That much is pretty clear. But be careful: even if you obtained your monopoly position legally, you can and likely will be accused of defending or maintaining it through anticompetitive tactics.

Second, the government (or private parties) can attack the monopoly as illegally obtained. Monopolies obtained through acquisition, predatory pricing, exclusive dealing, or tying and bundling can be subject to challenge. In extreme cases, the monopolist can be broken up; more likely the suspect practices will be prohibited in the future or an acquisition or merger blocked.

Third, the government can directly regulate the monopoly. This is the approach that has been taken for decades to the local telephone business as well as other utilities such as electricity. Regulation makes the most sense when the monopoly is unlikely to be eroded by entry or technological change. In theory, the regulation will wither away when no longer needed. In practice, as revealed by the Interstate Commerce Commission in railroads and the Civil Aeronautics Board in the airlines, to name just two, regulatory agencies create their own constituencies and often outlive their usefulness. So far, at least, no one is advocating the establishment of an Internet Commerce Commission.

Thankfully, large swaths of the information sector of our economy are subject to little or no regulation. In these industries, the rules of conduct are set by the antitrust laws in the United States and abroad. Every manager in the network economy is well advised to have a general understanding of the types of business practices likely to run afoul of the antitrust laws. But you should not think of antitrust merely as something to defend against; you may also be able to use antitrust offensively to prevent other firms from engaging in predatory conduct or from consummating a merger that would harm you as a buyer or exclude you from the market. In other words, you can also profit by knowing when your suppliers or competitors are breaking the rules so you can blow the whistle on them.

Implications for Strategy

As the public debate over Microsoft’s business practices illustrates, the line between aggressive competition and predatory conduct in the information economy is none too bright. Victory in the information economy, with its winner-take-all tendencies, inevitably generates ill will among the losers. Consumers, too, will complain if they feel locked in. Fortunately, such griping alone does not prove that a company has violated the law. What, then, are the legal limits on strategies involving lock-in, networks, and standards? What policies has the government pursued to promote competition in network markets? This section is a quick guide to fair play in the information economy.

The first rule to bear in mind is that monopolists are prohibited from employing certain strategies, even if the very same strategies are widely used and perfectly legal when employed by firms facing more competition. Microsoft tried to gloss over this point, suggesting that the Justice Department was threatening to interfere with every software company’s right freely to design its own products. Not so. At most, the Justice Department policies would limit the ability of monopoly software companies to modify their products where the effect is to extend the realm of the monopoly or reduce the choices available to customers.

All the same, you should not conclude that only leading companies such as Microsoft, Intel, and Cisco need concern themselves with competition policy. The fact is, each and every company in the information sector needs to be cognizant of antitrust rules and to fashion strategy with these rules in mind. For example, Iomega, the maker of those Zip drives that store seventy times as much as floppies, having successfully created a market for its product, has faced antitrust inquiries around the world relating to its product design, distribution practices, and enforcement of intellectual property. Iomega, a relatively small company, hardly imagined being confronted with these problems when it launched the Zip drive just a few years ago.

You are far better off anticipating legal challenges and planning your strategy to meet or avoid them than becoming enmeshed in complex and costly litigation and being forced to alter strategy as a result. The true sign of success may be that call from the Justice Department, concerned that you have monopolized your market. But once the excitement wears off, you will want to make sure you can justify your practices as legitimate competitive efforts rather than predatory or exclusionary.

Even if you think you are nowhere near having a monopoly, you still need to pay careful attention to how antitrust rules affect your industry. There are three unpleasant surprises that firms operating in information technology businesses commonly face:

1. Virtually any acquisition or merger will be reviewed by the antitrust authorities. If you are joining forces with a rival, making your case will require careful planning, antitrust lawyers, and detailed economic analysis.
2. Antitrust sensitivities are raised whenever you meet and talk with your rivals—for example, for standard-setting purposes. This argues for carefully documented and managed meetings and negotiations.
3. You may be accused of being a monopolist, especially if some of your consumers are locked in. To defend yourself, you will need to establish either that you lack genuine and lasting monopoly power or that your conduct was legitimately competitive, not exclusionary or predatory.

Mergers and Joint Ventures

Mergers and joint ventures that “may substantially lessen competition” are illegal. The vast majority of mergers are perfectly legal, but mergers involving direct rivals are typically subjected to antitrust review by the Justice Department or the FTC. The two laid out their basic approach to analyzing mergers in 1992 in their “Horizontal Merger Guidelines.” Mergers will be blocked if they are found to harm consumers, owing to either higher prices or lower quality.

In our view, there is no need for special laws to handle mergers in information industries. The antitrust agencies are very sophisticated in their merger reviews and have developed substantial expertise in many high-tech industries, including telephones, cable television, and computer software and hardware. For example, the Justice Department conducted an extensive review of the proposed Worldcom/MCI merger, looking at various Internet markets as well as long-distance telephone service. Both the Justice Department and the FTC recognize that certain high-tech industries are highly dynamic, making any monopoly power transitory. They are unlikely to challenge mergers in these industries because of the low entry barriers in these rapidly changing environments.

On the other hand, there is no antitrust immunity for software mergers, and the Justice Department and the FTC correctly recognize that entry may be difficult because of high consumer switching costs and the intellectual property rights of incumbents. Several software mergers have indeed been challenged and then either abandoned or modified as a result: Adobe/Aldus in graphics software, Microsoft/Intuit in personal financial software, Silicon Graphics/Alias/Wavefront in high-end software for graphics workstations, Computer Associates/Legent in utility software for IBM mainframes, and Cadence/CCT in electronic design automation software. We believe government policy in this area is well developed and works from a sound basis.

Cooperative Standard Setting

Price fixing, collusion, cartels, and bid rigging are per se illegal in the United States and can constitute a criminal violation. This policy is not controversial. Collusion will be investigated and acted on by antitrust authorities. The problem comes in the gray area between “collusion” and “cooperation.”

Adam Smith once said that “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” We wonder what he would have thought of standards negotiations, which require firms to “meet together.” The public policy concern is that participants will use the opportunity of meeting to stifle competition. Federal antitrust authorities must ask themselves: is this a standard-setting process, or is it a cartel?

In the area of information technology, we are most concerned about actual and perceived limits on firms agreeing to establish product standards. Product standards, interfaces, and compatibility are critical to the efficient flow of information and introduction of information technologies. It would be ironic, and troubling, if the antitrust laws, in the name of protecting competition and consumers, discouraged the creation and adoption of new products and technologies simply because they entail cooperation and agreements by competing firms.

While the antitrust authorities generally don’t like rivals getting together to negotiate product characteristics, it is clear that the public interest is very often enhanced by standards agreements. The question the antitrust authorities must ask themselves is whether the technology would be developed expeditiously without any standard-setting process. If the answer is that technological development would be slowed down or impeded entirely, or that consumers would lose important compatibility benefits, then the antitrust authorities should condone, and even encourage, the standard setting. Widespread participation or support by consumers will defuse, if not entirely forestall, any antitrust challenge to a standards agreement.

However, the antitrust authorities and the courts are likely to look with disfavor on negotiations that go beyond an agreement on product standards. Agreeing on product standards is a far cry from agreeing on the prices or terms at which the products will be sold. To use a sports analogy, the standard-setting process should be thought of as forging an agreement on the rules of play—the size of the playing field, the type of ball used, and so on. But once the rules of play have been established, you have to go out onto the field of play and compete vigorously and independently.

Fortunately, we believe that companies honestly engaged in efforts to establish new compatibility standards have little to fear from antitrust laws. Historically, antitrust law has placed only modest limits on the ability of competing firms to establish product standards. During the 1980s, the Supreme Court affirmed two antitrust judgments against companies setting performance standards. In one case, several manufacturers of steel conduit for electrical cable conspired to block an amendment of the National Electric Code that would have allowed the use of plastic conduit. The steel group was found to have hired people to pack the standard-setting meeting. In a second case, a trade association was involved in misrepresenting its standards, with the effect of declaring a rival company’s products unsafe.

Although some might see these cases as warnings for those who would meet to set standards, we think the greater danger is for companies to overreact and miss opportunities for beneficial cooperation. First, we consider the distinction between performance standards and compatibility standards significant. Plaintiffs in both of the cited cases were companies whose products were branded as unsafe. Open compatibility standards cannot have such an effect. Second, both of these cases involved abuse of the standard-setting process rather than any attack on the legitimacy of standard setting itself.

A good example of a standard that passed antitrust muster is that of the Motion Picture Expert Group (MPEG). The group was formed in 1988 to design technical standards for compressing digital video and audio data. The current version of the MPEG standard, MPEG-2, is used in digital TV, DBS, digital cable systems, personal computer video, DVD, interactive media, and CDs. MPEG-2 was developed under the auspices of the ISO, the IEC, and the ITU. On seeing everyone getting onto the bandwagon, Microsoft decided to include MPEG in Windows 95. MPEG-2 is now arriving for personal computers.

In June 1997, the Department of Justice approved a plan of eight companies, along with Columbia University, to combine twenty-seven MPEG patents into a single portfolio and license the inventions centrally. The eight companies are Fujitsu, General Instrument, Lucent, Matsushita, Mitsubishi, Philips, Scientific-Atlanta, and Sony. They researched some 9,000 patents to look for those essential to the MPEG-2 standard, since it was important to cite in the antitrust review that there were no practical alternatives to these patents.

Trade associations have been dealing with antitrust rules for decades, so the rules of the road are pretty clear when it comes to most cooperation. Consider, for example, the recent formation of IOPS.org. This is an industry group of large ISPs that “will focus primarily on resolving and preventing network integrity problems, addressing issues that require technical coordination and technical information-sharing across and among ISPs. These issues include joint problem resolution, technology assessment, and global Internet scaling and integrity.”²

The telecommunications industry and the Internet, in particular, require interconnection, standardization, coordination, and other sorts of cooperation with competitors. Meeting with competitors can raise antitrust concerns, but we think that so long as the companies stick to their stated goals, it is highly unlikely that their activities will be judged illegal.

Having said this, the fact remains that many companies are spooked by the antitrust laws and are wary of negotiating with actual or potential rivals on product specifications or protocols. Inasmuch as these companies may be subjected to private lawsuits, both from aggrieved competitors and from class-action lawyers, potentially facing treble-damage claims, this wariness is understandable. We are aware, for example, of an ongoing lawsuit claiming that Sony, Philips, and others violated U.S. antitrust laws by agreeing to establish a standard format for compact disks. U.S. firms face greater legal exposure in collectively setting product standards than do their foreign counterparts, because the United States uniquely permits private antitrust actions combined with class actions and treble damages. Recent legislation has removed treble damages for certain research and production joint ventures. Further protection for participation in standard-setting activities may well be warranted.

Agreements to promote a common standard often go hand in hand with agreements to share patents and technology that enable the standard. Thus, the legal treatment of standard setting is tightly wrapped up with the treatment of cross-licenses, grantbacks, and patent pools. While the courts and the antitrust enforcement agencies clearly recognize the pro-competitive aspects of both standards and the sharing of intellectual property, they are also actively looking for abuses of the process, situations in which the participants have gone too far, stifling competition under cover of a standards agreement. While we hesitate to offer legal advice, the general principle here is that parties to a standards agreement need to be prepared to argue that their overall agreement benefits consumers and the public interest, not just their own interests, and that the scope of their agreement is not overly broad to achieve its beneficial purpose.

Finally, companies forming networks and setting standards must determine the conditions on which others will be permitted to interconnect with or join their network. These issues have been faced repeatedly by banks joining to form an ATM or a credit card network. Although these networks are rarely challenged as naked price fixing, rules limiting the addition of new members to the network have been challenged, as in Discover’s lawsuit against Visa. Visa won, but the Justice Department has an ongoing investigation of the credit card industry, especially into the practices of Visa and MasterCard.

We recognize that both real and virtual networks can wield substantial economic power, because consumers often place great value on using a predominant standard. Even so, we tend to take the view that a group of firms forming a network has the right to choose with whom they will interconnect and on what terms they do so. We are more skeptical of exclusivity rules that limit network members from participating in other networks, especially when these rules are promulgated by ventures with significant monopoly power. Indeed, rules insisting that members not belong to other networks have been blocked, as in the Justice Department action against FTD, the floral network, and the European Union’s action against Visa striking down its exclusivity rules.

Single-Firm Conduct

Mergers, joint ventures, and standard setting all involve more than one firm. Unilateral conduct can also run afoul of the antitrust laws, if it constitutes “monopolization.” The hard part is distinguishing the firm that successfully competes, and thus gains a very large market share, from the firm that somehow crosses the line and gains a monopoly using tactics that are unfair, inefficient, or harmful to consumers, and thus illegal.

Certain commercial practices are a red flag to antitrust authorities. Exclusive dealing provisions are in this category: a monopolist who insists that its customers not deal with its competitors is in for some tough questions. Tying is another suspect practice: a monopolist who insists that customers take another product if they want the monopolized item are likely to be challenged. This sounds simple, but it can be devilishly hard to determine whether there really are two products involved instead of one. Was it tying for Ford to ship all of its cars with tires on them? Was it tying when Ford decided to put radios in its cars, thus posing a grave threat to the independent companies that had previously sold radios for installation into Ford cars? Ford was in fact challenged for changing the design of its dashboards—that is, the interface between cars and radios. We predict that these issues will become even more important in the years ahead because so many high-tech products interconnect with each other to form a system.

The most visible recent example of a tying problem has been the battle between the Department of Justice and Microsoft over Internet Explorer. The legal discussion has focused on whether Internet Explorer is a separate product or merely part of an “integrated” operating system. It is unfortunate that this almost metaphysical issue has become the focus of the debate, since the much more important question is Microsoft’s conduct vis à vis OEMs, content suppliers, and other providers of complementary goods and services. How Microsoft fares with Justice may ultimately turn on whether or not Microsoft’s contracts are exclusionary. As we noted earlier, Microsoft has already abandoned some restrictive licensing practices in the face of antitrust scrutiny both in the United States and in Europe.

This is not the first time that the computer industry has provided the field on which antitrust and high technology have collided. All during the 1970s, the Justice Department fought IBM, only to drop its suit in the early 1980s, even as IBM’s power was subsiding due to market forces. During the 1990s, Microsoft has been the test case. Did Microsoft gain its monopoly over desktop operating systems by legitimately competing on the merits, or through anticompetitive tactics? In 1994, the Justice Department concluded that Microsoft had violated the antitrust laws in the way it structured its contracts with computer manufacturers, and Microsoft agreed to modify those contracts. The Microsoft case has evoked a great deal of commentary on both sides: those who say antitrust should keep its nose out of the dynamic computer industry, and those who say Microsoft is a dangerous monopolist that got away with a slap on the wrist.

We will hardly resolve the debate over Microsoft here. We believe a cautious approach toward antitrust policy and enforcement is called for in high-technology industries, in part because technological change does tend to erode monopoly power and in part because much of the conduct at issue has at least some claim on increasing consumer welfare. For example, when Netscape complains that Microsoft will drive Netscape from the market by incorporating its own browser, Internet Explorer, into Windows, one must ask whether consumers will indeed benefit from a greater integration of the browser and the operating system. In other words, assessing whether practices such as bundling the browser into the operating system are pro- or anticompetitive is a difficult, fact-specific process that involves a balancing of competing concerns. We can say no more, except to question whether these disputes are best handled in the courtroom with a lay jury or through some more sophisticated forum for dispute resolution.

DIRECT GOVERNMENT INTERVENTION

Direct government regulation of prices, quality, interconnection, and entry is a necessary evil to be used when the competitive process, supplemented and protected by antitrust law, breaks down. The obvious piece of the information economy currently subject to this type of regulation is the telephone system.

The big news of the past few years in regulating the information infrastructure must be the Telecommunications Act of 1996. We heartily endorse Congress’s intention to break down artificial barriers between various telecommunications markets and to open local telephone markets to competition. The irony behind the act, however, is that the goal of local telephone competition, and thus the demise of regulation, can be achieved only with the help of a massive new set of regulations. Competitive local exchange carriers cannot get a foothold in the market without the cooperation of incumbent carriers in a myriad of ways: interconnecting to complete calls, enabling customers to keep their telephone numbers when switching carriers, leasing pieces of the incumbent’s network to would-be competitors, and much more. As one of us put it in a speech last year: “Regulation: The Path to Deregulation.”

Government regulators, including the FCC and state public utility commissions, should move aggressively to ensure that the conditions necessary to allow local telephone competition to flourish are indeed put into place. Competition will create pressures for companies to offer attractive packages of existing services, such as wireless and long distance, and new services, such as residential broadband and improved Internet access.

We welcome regulatory policies designed to control monopoly pricing, but we are even keener on policies that help transform monopoly markets into competitive ones, where technology permits. We caution that such a transformation of the telephone industry will take place only very gradually, however, making regulation necessary for many years to come. We also must note that regulation brings its own dangers: a regulatory structure created to control monopoly power can easily be used to serve other purposes, in particular, to support a system of cross-subsidization. Inevitably, the services that are providing the cross-subsidies are stifled: long-distance telephone calling has long been burdened by such cross-subsidies, which are the enemy of an efficient telecommunications policy.

Cable television regulation reveals another set of dangers associated with regulating information industries. In principle, municipal awards of cable franchises should work well, with municipal officials looking out for the interests of their subscriber/citizens. In practice, the federal government has become heavily involved, lurching from the Cable Act of 1984, which made it harder for municipalities to control their franchisees or replace them, to the Cable Act of 1992, which instructed the FCC to develop rates for basic cable services.

Congress has also legislated various rules governing the vertical relationships in the television industry. Congress imposed “must carry” rules on cable operators, requiring them to carry certain local television stations (these were recently upheld by the Supreme Court as constitutional). Congress, always keen to keep broadcasters happy, also has mandated that cable operations obtain “retransmission consent” from broadcasters before carrying their programming. So-called “program access” rules regulate the terms on which vertically integrated cable operators must make their programming available to direct broadcast satellite rivals. In addition, the FCC has imposed limits on how much “affiliated” programming cable operators may carry. These are not unlike the widely criticized “financial syndication rules” that long limited the ability of broadcast networks to take a financial interest in programming.

Regulations like these, which control and circumscribe the vertical relationships between those who produce content and those who distribute it, are increasingly out of place as the creation of content and the distribution of information become more and more competitive. Surely, whatever power CBS, NBC, and ABC had in the 1950s has been eroded with the arrival of Fox and the many cable networks. Hopefully, the monopoly power enjoyed by cable operators will also erode as direct broadcast satellite becomes a stronger force and as telephone companies enter into multichannel video distribution. In this setting, regulations on vertical relationships in the information sector may well serve to benefit certain special interests rather than the public interest.

Our rule of thumb for regulation in the information sector is simple: government regulation should focus on controlling genuine monopoly power when it will not be eroded by competitive pressures. Regulation of basic cable rates by municipalities, or of basic telephone rates by state public utility commissions, fits this description. So do rules to force open monopoly markets, such as those required by the Telecommunication Act of 1996 as a quid pro quo for allowing local Bell telephone companies into long distance. But the government should refrain from imposing rules that limit the ways in which companies in the information industry deal with those in adjacent markets, unless these rules have a direct and clear role in limiting horizontal monopoly power.

Government regulators can also take steps to encourage new entry into monopoly markets by awarding government franchises to new entrants. The FCC took a step in this direction in the early 1980s by setting up two cellular telephone carriers rather than giving local telephone companies complete control of the cellular business. More recently, through the PCS auctions, the FCC has moved strongly to inject far more competition into the wireless telephone business. In many cities, several PCS licensees will soon compete with the incumbent cellular providers. FCC policies prohibiting cellular providers from bidding on in-region PCS licenses helped ensure that new competition would truly emerge. Similar issues arise in the awarding of satellite slots for direct broadcast satellite, which is turning into a true competitor for cable companies in multichannel video distribution.

The Government’s Role in Achieving Critical Mass

The government does more than just impose regulatory rules as a way of promoting competition and innovation. The government can affirmatively finance, endorse, and adopt technologies to speed their widespread use. Of course, this is common in the defense sector, where the Pentagon is often the sole customer of a weapons system, but the same principles apply to the government as merely a large and influential buyer of a commercial system.

We saw in Chapter 7 that information and communications technologies often exhibit network externalities. There is a long, slow increase in their use until some critical mass is reached, after which the growth rate explodes. Once network goods obtain sufficiently wide use, the market may be an effective way to provide them. However, there may be a government role in helping such industries obtain critical mass. The Internet is a prime example. It is unlikely that the Internet would have achieved its current level of popularity without early subsidization by the government. Demonstration projects can help an industry achieve critical mass. Yet some would blanch at the notion of the government ultimately deciding which of several rival technologies will succeed in the market. Thankfully, the private sector is not saddled with the same computer system used by the Internal Revenue Service!

In other words, one should not jump to the conclusion that an active government role is needed to kick-start an emerging technology. Do not underestimate the ingenuity of the private sector to find ways to solve the chicken-and-egg problem. Many highly successful technologies would not have been viable had the private sector not been able to achieve the necessary coordination to build critical mass. In the consumer electronics area, the private sector regularly organizes itself to solve chicken-and-egg problems. Video cassettes and VCRs are strong complements and are subject to indirect network effects: the demand for VCRs depends on the availability of video cassettes and vice-versa.

In the early 1980s, private video rental stores managed to achieve critical mass by renting out VCRs along with the cassettes. This allowed the video stores to achieve sufficient market penetration to stimulate the demand for the purchase of VCRs. Similar factors arise for video game machines, compact disk players, and the new digital video disk players. There are strong incentives for private parties to internalize network externalities, either through integration (as when Nintendo sold an entire system, consisting of a machine and proprietary games) or contract (as when Sony and Philips agreed to license their CD technology widely to get the CD bandwagon rolling).

Thus, we see a government role primarily in cases where network externalities are difficult to internalize, as when basic technology must be shown to be technologically feasible. We also see an important role for the government as a large, and perhaps pivotal, user of certain new technologies. The government, in lending its support to a particular technology or standard, can and should take into account private interests, not merely its own interests as a consumer of technology.

Universal Service

Since the value of the network depends on the total number of people connected to it, one often hears arguments that network goods should be universally provided. The mantra of universal service has long been part of telephone policy, and there are those who argue that universal service is now an appropriate public policy goal for Internet access.

We quite agree that widespread availability is desirable for many kinds of networked goods. However, it is a large leap from there to say that such access should occur only through government provision or subsidies. After all, many goods with network externalities are provided by the private sector, including our original example, fax machines, and the VCR/video cassette market discussed above.

Basic telephony service has long been regarded as a good that required a deliberate policy effort to achieve universal access. However, a close reading of history raises doubts. Empirical studies suggest that penetration of basic telephony services could easily be comparable with today’s rates, even if there had been no policies of subsidized access. Various comments to the FCC in its recent docket on universal service reform indicated that the current structure of pricing in telephony is costing the United States billions of dollars in inefficiency, with very little impact on penetration rates for basic telephone service. To support universal service, prices of long-distance calling have been kept well above cost to support below-cost prices for basic telephone service. Studies clearly show that customers are far more sensitive to price in their long-distance calling patterns than they are in the use of basic service. As a result, the pricing patterns supporting universal service are in direct violation of basic economic principles of efficient pricing to cover joint and common costs, which call for markups to be lowest on services for which customers are the most price sensitive. In addition, the FCC recently admitted that its plans to provide subsidies to wire schools and libraries around the country will cost far more than originally estimated.

Advocates of universal service for Internet or telephony typically make their case on grounds of geography or income. One can well see why interested parties might argue for geographic subsidization: economic theory suggests that most of the benefits of offering services to an isolated area will be captured by those who own property in the area. Land with electricity service, telephone service, and road service is certainly more valuable than land with none of these features, and it is, of course, appealing to those who own the land to get someone else to pay for such improvements.

What is forgotten in this discussion is that those who live in rural areas have many advantages over urban dwellers. Crime rates are lower, housing is cheaper, and parking is inexpensive. What is the point of charging urbanites a price higher than cost for telephony service in order to subsidize access by rural dwellers, if all these other “inequities” persist? Overall, it makes more sense to have people face the true cost of their location decisions: if choosing clean air and low crime carries with it a higher cost of telephony service, so be it.

The case with respect to income is not so clear cut. Economists use the term merit goods to designate certain goods that are so important that they should be provided for everyone. However, we think that basic necessities such as food, shelter, and health care are much better candidates for merit goods than telephone service or Internet access. In any event, if universal service subsidies are to be provided, they should be limited to those with low incomes and to services that have been demonstrated to generate significant network externalities. Even if basic telephone service meets this test, second lines, for example, would not. Even though each of us has several lines in our home, we are pleased to see that the FCC recently made moves to raise the price of second lines (and business lines) closer to cost.

It is also important to understand clearly the reasons that the poor do not have access to goods such as telephone service. One study found that a higher fraction of low-income households in Camden, New Jersey, had VCRs than had telephones. The most important reason that people chose not to have telephones was that their friends and relatives would make long-distance calls and stick them with the bill! The monthly charge for basic access was not a significant factor in their choice of whether or not to purchase telephone service. Such a finding, if generally true, suggests a need for policies designed to achieve universal service very different from those that have been used in the past.

LESSONS

No executive in the technology sector can ignore the government’s role in the information economy. And no government policy maker can fashion intelligent policy without a sound understanding of competitive strategy in the network economy. Here are our observations and predictions about government information policy:

• Don’t expect the government’s role to diminish. Information technology is subject to large increasing returns to scale on both the demand and the supply side. Market outcomes in such industries will inevitably tend to be somewhat concentrated and require industry standardization and coordination. The resulting monopolies and standards will continue to attract the attention of government antitrust enforcers, both in the United States and abroad. Nor will telephone regulation soon wither away. To the contrary, the Internet infrastructure is bound to become more regulated in the years ahead.
• Every company needs to know the rules of competition. You are far better off anticipating antitrust challenges, both from private parties and from the government, when you first fashion your strategy or plan an acquisition than you are having to adjust strategy later. Understanding competition policy also helps you to protect your interests when other companies are breaking the rules.
• Companies have considerable freedom to engage in differential pricing. Versioning and differential pricing are effective tools for cost recovery in industries with large fixed costs and small marginal costs and are only rarely subject to antitrust attack.
• Competition policy is intended to ensure a fair fight, not to punish winners or protect losers. If you manage to dominate your market by offering lower prices and better products, you have nothing to fear from the antitrust laws. By the same token, if you lose out in a fair fight, don’t expect the antitrust laws to provide you with any comfort.
• Mergers and acquisitions involving direct competitors are subjected to careful review by the Justice Department and the Federal Trade Commission. To close your deal you need to convince these agencies that your acquisition will not harm consumers.
• Don’t be afraid of cooperating with other companies to set standards and develop new technologies, so long as your efforts are designed to bring benefits to consumers. If you steer well clear of the antitrust hot-button areas of pricing and product introduction, and are genuinely working to establish and promote new and improved technologies, you are on solid ground and should be well protected from any antitrust challenge.
• If you are fortunate enough to gain a leading share of the market, be sure to conduct an audit of your practices. This audit should encompass your pricing, bundling, and distribution practices as well as any exclusivity provisions in contracts with customers or suppliers. You will then be well prepared to deal with antitrust challenges, should they arise.
• Don’t expect government regulation in the telecommunications sector to diminish any time soon. Telephone regulation is meant to wither away as competition takes root; don’t hold your breath. And Congress has repeatedly shown a hearty appetite for regulating the broadcasting and cable television industries. Internet, watch out.